Why Index Funds Beat Actively Managed Funds
While actively managed funds may perform well in the short-term, most underperform the market after one year. Index funds, meanwhile, tend to have higher returns over longer periods of time. This is because the index fund, a type of mutual fund or exchange-traded fund (ETF), is designed to follow predetermined guidelines in order to track a specific underlying set of investments, and is therefore passively managed.
Index funds, such as the best S&P 500 index funds, are intended to match the holdings (company stocks) and performance of a stock market benchmark, such as the S&P 500.
Thus, there is no need for the intense research and analysis required to actively seek stocks that may do better than others during a given time frame. This passive nature allows for less risk and lower expenses.
Fund managers are human, which means they are susceptible to human emotion, such as greed, complacency, and hubris. By nature, their job is to beat the market, which means they must often take an additional market risk to obtain good returns.
Therefore, indexing removes a kind of risk that could be called "manager risk." There is no real risk of human error with an index fund manager, at least in terms of stock selection.
Also, even the active fund manager who is able to avoid the trappings of their own human emotion can't escape the irrational and often unpredictable nature of the herd. As the famed economist, John Maynard Keynes once said, "The markets can remain irrational longer than you can remain solvent."
In other words, the most experienced fund manager with the greatest knowledge, skill, and emotional control cannot consistently and successfully navigate the insanity of the crowd.
Mutual funds don't create themselves and those who offer mutual funds to the public need to receive some level of compensation for their efforts. But as noted above, index funds are passively managed, therefore the cost expressed as an expense ratio, of managing the fund is extremely low compared to funds that are actively engaged in beating the market averages.
In other words, because index fund managers aren't trying to beat the market, they can save money by keeping management costs low and keeping those savings invested in the fund.
In 2019, index fund expense ratios averaged 0.07%, whereas the average actively managed mutual fund had expenses of around 0.74% or higher. This means that on average, an index fund investor can begin each year with a 0.67% head start on actively managed funds.
This may not seem like a big advantage, but a 0.67% or more lead on an annual basis makes it increasingly difficult for active fund managers to beat index funds over long periods of time.
Even the best fund managers in the world cannot consistently beat the S&P 500 for more than five years, and a 10-year winning streak is almost unheard of in the investing world.
Index funds, especially the best S&P 500 index funds, maintain large numbers of investors and high levels of investor assets. They don't have sudden peaks or troughs in popularity or trendiness. This is a strength.
By contrast, many actively managed mutual funds become popular because a fund manager has beaten the market consistently for more than a few years. As more and more investors become aware of the positive trend, the mutual fund attracts more assets (investor money).
This can be negative in two ways. First, the fund manager may be forced to buy more shares of larger companies or stocks (this is called style drift). Second, the hot streak will end and investors might then leave the fund, creating a liquidity issue—the manager must sell stock holdings to create cash for exiting investors, which slows performance for remaining investors.
One of the central ideas of investing in all categories of mutual funds is to make investing easier and more accessible to the average or beginning investor. But choosing the best mutual funds can be time-consuming.
Investing in index funds minimizes the time and energy spent on researching funds and managing one's portfolio, freeing up time for one's priorities in life, which the money you've invested is intended to finance in the first place.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.